Relationship between OPTION GREEK with DEGREE of MONEYNESS, IMPLIED VOLATILITY and TIME TO EXPIRATION: Summary – Part 2

Go back to Part 1.

THETA
Theta is an options greeks that measures of the rate of decline of option’s time-value resulting from the passage of time (time decay).
Theta provides an estimate of the dollar amount that an option price would lose due to 1 day decrease in the time remaining to expiration, assuming other factors remain constant.

Theta of ATM, ITM & OTM Option
Theta is typically highest for ATM option, and is progressively declining as an option moves to ITM or OTM.
This makes sense because ATM options have the highest time value component, so they have more time value to lose over time compared to ITM or OTM options.

Effect of Time Remaining to Expiration on Theta
For ATM option, Theta will be higher as an option is approaching the expiration date.
In contrast, for ITM & OTM options, Theta will be lower as an option gets closer to expiration. The above effects are particularly observed in the last few weeks (about 30 days) before the expiration.

Impact of Implied Volatility (IV) on Theta
When Implied Volatility (IV) decreases, Theta will decrease, especially when it is approaching expiration.
On the other hand, when IV increases, Theta would also increase.

VEGA
Vega measures how sensitive an option’s price to the changes in Implied Volatility (IV). Vega estimates how much an option price will change as a result of 1% change in volatility.

A change in IV will have the same effect on both Calls and Puts options:
An increase in IV would increase an option’s price, whereas a decrease in IV will decrease an option’s price.
This is because higher volatility implies greater expected fluctuations in the stock price, which means a greater possibility for an option to move into your favor by the expiration date.

Vega of ATM, ITM & OTM Option
Vega will be the highest for ATM options, and would gradually get lower as options become more ITM and OTM.
That means, when there is a change in volatility, the value of ATM option would change the most. This makes sense because ATM option has the highest time value component, and that the changes in IV will only affect the time value portion of an option’s price.

Comparing between ITM & OTM options, the impact of volatility changes will be greater for OTM options than it is for ITM options.

Effect of Time Remaining to Expiration on Vega
Assuming all other things constant, Vega decreases when as time passes (as the option gets closer to the expiration).
Vega is relatively higher when there is more time remaining to expiration. This is because options with more time remaining to expiration have larger portion of time value, and it is the time value component that will affected by the changes in volatility.

Effect of Implied Volatility on Vega
Vega will be lower when IV decreases, especially for ITM and OTM options.
However, Vega is relatively stable / unchanged for ATM option.

Related Posts:
* Option Greeks
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Understanding Implied Volatility (IV)
* Understanding Option’s Time Value
* Learning / Understanding Candlestick Charts
* Learning Charts Patterns